Friday, April 29, 2011

An Attempt at De-Bafflement

This is for the baffled guy who wrote this. Here's a simple example, in case you did not get this. Suppose a financial intermediary that holds long-maturity Treasury bonds, and finances this portfolio with a sequence of repurchase agreements, with the Treasuries used as the collateral in the repos. Suppose also that this intermediary, and the counterparty in the repo transaction, both have reserve accounts with the Fed. Now, one morning, when the intermediary needs to repurchase the Treasuries, it sells the Treasuries to the Fed in exchange for reserves, then transfers the reserves to the repo counterparty. What has changed here? First, some private economic entity now has reserves instead of a collateralized overnight loan (repo), where the collateral was the Treasury bonds. Second, the Treasuries are now at the Fed instead of at a private intermediary. Nothing of substance has changed. The Treasuries used in the original repos are backed by the full faith and credit of the United States of America, as is the reserve account. Nothing of substance has changed. The only subtle difference here is that the repos can in principle be held by anyone, while not everyone can have a reserve account. But this goes the other way, in that the reserves, at the margin, are actually less "liquid" in some sense than the repos are.

If we make this more general by allowing for more complicated types of financial interemediaries, it should not matter. Thus, QE2 is irrelevant.

19 comments:

It would seem that the Fed could directly finance nominal spending if the stock of outstanding Treasuries grows as the Fed increases its holdings of them. Perhaps I am missing something.

In Latin America, it was expectations of deficit monetization that led, directly, to higher inflation expectations. Thus, as real growth slowed, deficit projections rose, and so did inflation expectations. The output gap was more or less irrelevant.

"It would seem that the Fed could directly finance nominal spending if the stock of outstanding Treasuries grows as the Fed increases its holdings of them."

The Treasury finances the spending. Then, the central bank in general has some say in how the financing takes place, through its purchases of Tresury debt. However, what I am saying is that under some conditions the Fed actually has no say in the matter.

You should have added that the reserves could have been redeemed for Federal Reserve notes, and still nothing important would have changed. Every issuance of money is either a swap of one liability for another, or a new liability matched by a new asset.

I have a request for further de-bafflement. Here’s how I understand your argument:

Intermediary X has excess cash and makes short-term (overnight) loans to intermediary Y which intermediary Y uses to buy long-term treasuries which also act as collateral for X’s loan.

Under QE2, the Fed buys the long-term treasuries from intermediary Y and pays for the purchase with reserves, i.e. it increases the balance in Y’s account at the Fed. Then intermediary Y transfers that balance to X to repay the short-term loan.

Therefore, X is still left with liquidity (excess reserves at the Fed rather than “excess cash”) and the question is what he does with it.

If X keeps his reserves at his Fed account, the only effect of QE2 is an increase in excess reserves with no impact on interest rates. I think this is your point (but correct me if I’m wrong).

But if X withdraws the money from his account to buy a long-term treasury (or to lend someone else to do it), then the interest rate on treasuries will fall in response to QE2. For some reason, it seems that many institutions have been happy to accumulate reserves, but then the question is why does this happen and will it necessarily happen in response to QE2.

Is this a fair representation of your argument and, more importantly, do you agree with the last point that if X “withdraws” his money from the Fed account, then QE2 could have an effect?

"But if X withdraws the money from his account to buy a long-term treasury..."

That's just it. X does not want to, as for some reason X just wanted to park some cash overnight, otherwise X would have bought the long Treasuries in the first place.

"I would venture to say that yields would be higher without the Fed buying."

You have not shown me why. You're not telling me how you are drawing this inference from the data.

"Have you given up on your "reserves can be converted to currency thereby causing inflation" story?" No. You see, in the story there is nothing that will change the demand for or supply of currency. The Fed of course has the tool to control inflation, which is the ability to increase the interest rate on reserves.

Why would a rational person accept negative real rates? Yield curve is steepest and the real rates most negative in the sector of the UST curve where the Fed is least involved. The simplest explanation is that the Fed is the cause of negative real rates in the front end of the UST curve.

The person buying 2 year notes at 60 basis points is not doing so because he expects to make a positive real return. Its a leverage arb who benefits by the roll down of the security and its huge positive carry thanks to the Fed. Fed over night rates are 10 basis points and the 2 year repo is -5 basis points.

Thanks for the clarification. I have two follow-ups (and hope you have the patience for them):

X could have parked the money at the Fed in the first place rather than lend it to Y. However, as a result of QE2, X finds itself with an increased balance at the Fed and the question is whether QE2 made X want an increased balance at the Fed with respect to before QE2.

Now, one morning, when the intermediary needs to repurchase the Treasuries, it sells the Treasuries to the Fed in exchange for reserves, then transfers the reserves to the repo counterparty. What has changed here?

One thing that might have changed are the terms of trade. Perhaps the Fed asks for a smaller haircut on the collateral? As a big player, the Fed could, in this manner, influence market interest rates. Or am I missing something here?

There is an intermediary in your example that "sells" its long-duration bonds for cash, agreeing to repurchase these bonds the next day. This is repo. The amount of cash acquired in this deal depends on the haircut; and this haircut is related to the short term interest rate.

If this repo transaction is rolled over day after day, the intermediary is effectively financing a long bond at short rates. But I guess I'm saying that these short rates depend on the market haircut applied to the long bond.

Now, one morning, when the intermediary needs to repurchase the Treasuries, it sells the Treasuries to the Fed in exchange for reserves, then transfers the reserves to the repo counterparty.

So now, instead of "selling" the treasuries to a private party, who is applying a market-determined haircut on the treasuries, the intermediary instead sells it to the Fed.

You asked: what has changed here? My answer is, nothing--as long as the Fed is offering the same haircut (interest rate) as the market did previously.

In the context of complete markets, Eggertsson and Woodford's 2003 BPEA paper proves an irrelevance result (page 157) similar to what you're saying here. "QE2 undone by private intermediation" is an intuitive argument for why liquidity effects don't exist in such a setting.

But when markets are not complete, there is short-term interest rate risk, and there is also risk that the financial intermediary will fail, I don't think this story is necessarily true. As David Andolfatto points out above, repo generally involves a haircut (otherwise the longer-maturity Treasury wouldn't be very good collateral), and presumably the size of that haircut is related to the perceived riskiness of the financial intermediary. Since the Fed, for better or worse, is considered by the market to be the least risky financial intermediary around, it can get away with offering a very small haircut, which makes its maturity transformation activities more effective. You can argue (as I think you did in your previous post) that this is misplaced, and that the "Treasury is no better equipped to share this loss among private economic agents than is the private sector". But in practice, I think that it's very difficult for the private sector to write contracts that replicate the risk-sharing abilities of the Treasury—which is also a big part of the reason why there is such an impressive liquidity premium on Treasury securities.

You are a University Professor, I do not expect you to acknowledge that you have changed your views on excess reserves (how many university professors have confessed to have changed their economic views in the last 100 years?). The academic ego is just pathetic.

This being said, you have done a 180 degree turn on excess reserves. No need to ackowledge it though.

Welcome in the selective "excess reserves are just like T-Bills" Club. You are in good company in this club (Post-Keynesian, modern money theorists, etc)